In July, the AICPA’s Auditing Standards Board (ASB) unanimously voted to propose revisions to the audit standards on the use of accounting estimates. The ASB wants to improve the standards because financial statements increasingly contain estimates that are difficult to measure and verify. Here’s how and when estimates are used in financial reporting — and why the ASB is revising its standards.
Accounting estimates may be based on subjective or objective information (or both) and involve some level of measurement uncertainty. Some estimates may be easily determinable, but many are inherently subjective or complex. Examples of accounting estimates include allowances for doubtful accounts and impairments of long-lived assets.
Fair value measurements are another type of accounting estimate. Under U.S. Generally Accepted Accounting Principles (GAAP), a fair value measurement represents “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
Accounting estimates and fair value measurements involve a high degree of subjectivity and judgment and may be more susceptible to misstatement. Therefore, they require more auditor focus.
Auditing standards generally provide three approaches for substantively testing accounting estimates and fair value measurements. When performing an audit, the auditor selects one or a combination of these approaches:
- Testing management’s process. Auditors evaluate the reasonableness and consistency of management’s assumptions, as well as test whether the underlying data is complete, accurate and relevant.
- Developing an independent estimate. Using management’s assumptions (or alternative assumptions), auditors come up with an estimate to compare to what’s reported on the internally prepared financial statements.
- Reviewing subsequent events or transactions. The reasonableness of estimates can be gauged by looking at events or transactions that happen after the balance sheet date but before the date of the auditor’s report.
Updating the standards
The AICPA wants to improve the standards on auditing accounting estimates to help auditors better address increasingly complex financials. It also wants auditors to focus on factors driving estimate uncertainty and potential management bias. Company management has an incentive to record estimates that make their books better. Moreover, inspection findings have shown that this is an area in need of improvement.
The ASB’s proposal would supersede Statement on Auditing Standards (SAS) No. 122, Clarification and Recodification: AU-C Section 540, “Auditing Accounting Estimates, Including Fair Value Accounting Estimates, and Related Disclosures.” The proposal would enhance risk assessment procedures and be scalable from difficult to relatively simple estimates.
“The proposed SAS is intended to address the challenges auditors face when auditing accounting estimates by providing risk assessment requirements that are more specific to estimates, and that address the increasingly complex business environment and complexity in financial reporting frameworks,” states a draft version of the proposal. “The proposed SAS focuses on how complexity, subjectivity and estimation uncertainty are taken into account when identifying and assessing risks of material misstatement.”
The ASB’s effort to revise the auditing standard of estimate is part of a broader strategy to converge its standard with guidance published by the International Auditing and Assurance Standards Board (IAASB). Last year, the IAASB finalized new auditing standards to address the auditor’s responsibilities on accounting estimates in an audit of financial statements.
Eye on estimates
In 2019, the AICPA’s Enhancing Audit Quality Initiative identified accounting estimates as an area of focus. In fact, nonconformity in this area is the most common audit issue detected by practice monitoring programs worldwide. The revised auditing standards strive to bring consistency and clarity to this complex aspect of financial reporting, as well as to reduce errors and restatements.
Using specialists to make estimates
Auditors and managers often call on specialists to help them make subjective estimates under U.S. Generally Accepted Accounting Principles (GAAP). Examples of specialists used to prepare public company financial information include:
- Actuaries to determine employee benefit obligations,
- Engineers to determine obligations regarding environmental remediation,
- Appraisers to determine the value of intangible assets or real estate,
- Geologists to estimate mineral deposits or oil reserves for mining and energy companies, and
- Lawyers to forecast the potential losses from a legal proceeding.
In July, the Securities and Exchange Commission (SEC) approved a revised standard that aims to better reflect how an auditor uses the work of the different types of specialists. It will also strengthen the requirements for evaluating the work of a company’s specialist. The standard goes into effect for audits of public companies’ financial statements for fiscal years ending on or after December 15, 2020.
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